2 Reasons the May-June Correction May Repeat Itself in August

Watch these two news items for an indication of what's to come

The reaction to taper expectations in May and June was brief, but quite dramatic. Yesterday, we got some very important information that can help us make a forecast about whether this kind of correction is likely to repeat itself. This is important because it will help short-term investors (like us here at SlingShot Trader) know what groups are likely to decline or rise the most as we head into the middle of the third quarter. As we evaluate this information, it’s key to remember that expectations about the Fed’s behavior are what will drive trader forecasts.

Labor Forecasts Leading to Lower Bond Prices

The Fed has already communicated to the market that they will consider a taper when the unemployment rate falls and/or inflation rises. On Wednesday, we got a teaser report from ADP for July’s official labor report on Friday. The news was good, with ADP reporting that the United States added 200,000 new jobs versus the 179,000 jobs that were expected to be created. June’s report was also revised higher.

We don’t yet know how this news will affect the unemployment rate on Friday, but it is safe to say that it isn’t likely to reduce positive expectations for labor in the short term. We are already seeing a reaction to this news in the highest-yielding asset classes. Real estate, utilities and bonds are leading the way lower, which is exactly what happened towards the beginning of May.

Inflation Forecasts Could Put Pressure on the Fed

The first version of the GDP report for the second quarter was also released Wednesday, and it beat expectations. There have been some changes to the calculation, so we have to take the news with a grain of salt, but it is still better than a negative report. GDP includes inflation data, which was slightly lower than expected. Some analysts might expect that this would relieve the pressure on the Fed to taper, but the number isn’t reliable. Traders are going to focus more on the growth numbers themselves as a way to forecast inflation than the GDP price index. If growth is rising, inflation is expected to follow.

Inflation has a negative impact on bonds, which drives bond yields higher. In turn, this will put pressure on high-yielding stocks like utilities, consumer staples and REITs. It’s a little early to say for sure, but traders should be prepared for another move like we saw in May. This presents some interesting opportunities and risks.

The bottom line is that if the trend plays out the way we expect, higher-yielding stocks (with poor fundamentals) are likely to be the most attractive bearish trades in August. Similarly, stocks that seem to be of higher risk (financials, tech and small caps with strong fundamentals) are the most attractive bullish positions. Earnings season is starting to ebb, so these trades are also more likely to be in favor of the prevailing trend.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.

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